Efficient Breach of Contract: Remedies and Economic Implications

ECON 1450 – Professor BerkowitzLecture Notes -Chapter 5 • Remedies for Breach of Contract • Efficient Breach Model • Previous lectures – what promises should be legally enforceable? • Enforce contracts that are mutually beneficial • Suppose conditions change and a contract that was mutually beneficial is no longer mutually beneficial

Efficient Breach Model • Contract: buyer is a rock band • Contract: seller is music store • V = value of contract to buyer • C = cost of contract to seller – where C includes variable costs • Contract is socially efficient if V > C • Contract is socially inefficient if V < C

Uncertainty and Social Efficiency • Uncertainty over production costs • Uncertainty over value of performance to buyer • Uncertainty about offers from alternative buyers • Efficient breach rule versus individual incentives to breach

Money damages and efficient breach • Suppose there is uncertainty over production costs (C) • Buyer is homeowner, seller is contractor who is fixing homeowner’s kitchen • V = value of house is additional resale value after kitchen is fixed, P = price • Expected that V > P and P > C => then both parties go ahead with contract and contract is efficient

Reliance investment • R = reliance investment – example, homeowner hires moving company to deliver cabinets for kitchen on a particular day • R – an upfront investment by owner that is not salvageable – enhances investment for homeowner, but is a pure loss if the investment (kitchen repair) does not go through

Breach of contract • D = court imposed damage that contractor (seller) must pay buyer if there is a breach • What D incentivizes the contractor to breach “efficiently”? • Efficient contract: Joint return from contract is (V – P – R) + (P – C) = V – R – C, Joint return from breach is –R => efficient breach holds when – R > V – R – C or C > V!

Using D to get efficiency • Seller’s breach decision – seller’s return w. breach = - D, seller’s return w. contract is P – C • Seller breaches when C > P + D (interpret) • Efficient breach by seller occurs when C > V and C > P + D => D = V – P • Interpretation – D = buyer’s surplus

Efficient breach and actual rules • Expectation damages – money that leaves promissee (homeowner) just as well off as if contract had been performed: D = V – P • Reliance damages – money that leaves promissee as well off as if the contract had never been made: D = R • Under reliance damages sellers breach when C>P+D = P+R, where V > P+R, so seller breaches too much!

Actual rules – continued • Breach when D=0 • Seller breaches when C > P + D = P, and since V > P, the seller breaches too frequently! • See figure 5.1 • Check exercise 5.1

Incentives for Efficient Reliance • Suppose the homeowner can choose R • R is chosen to enhance resale value if contract goes through: V’(R) > 0 and V”(R) < 0 • R* chosen to maximize V(R) – R • Therefore, V’(R*) – 1 = 0

Realism – seller is uncertain about costs • Ch > CL, and Ch > V > CL • Contract is only efficient when costs are low • Probability that costs are low = q; probability costs are high = 1 – q • Efficient R: maximizes expected joint return which is q(V – R - CL) + (1-q)(-R) = • q(V – R) - R

R^ - efficient reliance • Max qV(R) – qCL – R • Max qV(R) – R • See Figure 5.2 – R^ < R* (case of no uncertainty) => buyer should invest less to account for losses when high costs are realized • Show that dR^/d(1-q) < 0 (or dR^/dq > 0)

Expect Damages and Uncertainty • Expectation damages D = V(R) – P • We want the buyer to invest efficiently in R and we want the buyer to efficiently honor or breach the contract • Seller efficiently breaches (we have already shown this!) • Buyer chooses R: max q(V(R)–R–P) + (1-q)(D-R)

Expectation damages continued • Since D = V(R) – P, then • Max q(V(R) – R – P) + (1-q)(V(R) – R – P) or • Max V(R) – R – P, or you get R* > R~, so buyer over-invests! • Expectation creates a moral hazard problem for the buyer! • Similar to under-investment of victim in tort model with strict liability!

Solution to problem • Efficient contract enforcement by seller and over-investment by buyer (moral hazard) • Analogy to negligence in contract law – set a due standard for buyer (R-due standard)… if buyer meets this and does not exceed it, then the seller pays for full damages for breach • There is no such remedy in contract law

Hadley v. Baxendale Rule • Read case on pp.114-115 • Damages for breech of contract are limited to a “reasonable level” • Interpretation – reasonable level = R^ (the efficient level under uncertainty) • Thus, D = V(R^) – P and • D = V(R^) – P < V(R’) – P, R’ is unlimited expectation damages!

Hadley v. Baxendale, cont’d • With unlimited damages, buyer get R’ and with expectation damages buyer gets R^ only • Expectation damages and buyer’s behavior • Choose R: Max qV(R) – R – P + (1-q)V(R^) or drop constants and max qV(R) – R • Under this rule, seller breaches or honors contract efficiently and buyer invests efficiently!

Mitigation of Damages • Example – owner of duplex agrees to rent an apt to a student for 12 months at $300 per month • After 6 months the student abandons apt • After 12 months, landlord files for $1,800 unpaid rent • Student notes that friend offered landlord $200 per month for remaining 6 months

Mitigation – cont’d • Landlord refuses to take on new lease holder • Student admits to breaching contract • Student also argues landlord should only get $600 • Court sides with student – “contractors have a duty to take on any reasonable (cost-effective) efforts to mitigate damages from breach!

Impossibility and related excuses • Impossibility • Frustration of purpose • Commercial impracticability

Commercial impracticability • Courts discharge contracts when performance is feasible but economically burdensome • Conditional rule that discharges performance without penalty when costs are sufficiently high

Specific performance • When is it efficient for the court to forego monetary damages (D) and, instead, order the promisor to perform the contract as written?

Efficient Breach of Contract: Remedies and Economic Implications